Index Monkeys Beat Cap-Weighting

Researchers have found that equity indices constructed randomly by 'monkeys' would produce higher risk-adjusted returns than an equivalent market capitalisation-weighted index over the last 40 years and that they could be a result of luck rather than design.

The findings come from a recent study by Cass Business School (CBS), which was based on monthly US share data from 1968 to 2011. The authors of the study found that a variety of alternative index weighting schemes all delivered superior returns to the market cap approach.

According to Dr. Nick Motson of CBS, co-author of the study, "all of the 13 alternative indices we studied produced better risk-adjusted returns than a passive exposure to a market-cap weighted index."

Professor Andrew Clare, the other co-author, added: "One of the implications of our work is that we should perhaps be benchmarking our fund managers against monkeys rather than against a cap-weighted index."

The study included an experiment that saw a computer randomly pick and weight each of the 1,000 stocks in the sample. The process was then repeated 10 million times over each of the 43 years. Clare describes this as "effectively simulating the stock-picking abilities of a monkey".

"The results of this experiment showed that many of the monkey fund managers would have generated a superior performance than was produced by some of the alternative indexing techniques. However, perhaps most shockingly, we found that nearly every one of the 10 million monkey fund managers beat the performance of the market cap-weighted index," said Clare.

The findings will be a boost to investors already looking at alternative indexing. Last year a number of European pension funds started reviewing their passive investment strategies, switching from capitalisation-weighting to alternative index methodologies.

John Belgrove, senior partner at Aon Hewitt, the firm sponsoring the study, said in a statement: "There has been a glut of so-called 'smart beta' investment products coming to market in recent years and we are keen to see some consistent academic rigour to help investors better understand some of the opportunities and risks available to them in this space.

"Inherent weaknesses in cap-weighted investment strategies are well documented, although they have been an enduring and challenging benchmark for active managers to beat. The long run results of the monkeys are therefore likely to cause some surprise and we welcome further debate. The good news for investors is that there is more implementation choice than ever to consider when selecting a preferred long term portfolio construction and fund manager style," Belgrove continued.

Out of the alternative indices, the sales-weighted index performed the best, beating 99 per cent of the monkeys' randomly constructed indices.